Here’s what you need to know about how agency costs affect corporations and some common examples you may find in the real world.
What Is Agency Cost?
A business’s owners and managers don’t always see eye to eye. Some actions would benefit one party over the other, so there’s a level of tension that persists. It is from this tension that agency costs arise. There are two types of agency costs, but they both stem from that same inherent tension between shareholders and managers. The first type of agency cost is when managers use resources to further their own goals—at the expense of shareholders’ goals (like when a manager books a luxurious hotel room during a business trip). The second type of agency cost is when shareholders spend resources to monitor managers and ensure that the first type of agency cost doesn’t occur (like when shareholders must review all travel expenditures to ensure that managers didn’t book overly expensive hotels).
How Does Agency Cost Work?
Agency costs occur when the shareholders and management diverge on their ideas of actions a company should take. Shareholders may want to pursue one course of corporate action to maximize shareholder wealth, and the managers—including the board of directors, the CEO, and other high-level officials—want to pursue another course. Specifically, these two parties are diverging on whether or not to do something that may be particularly beneficial to these same managers. Large corporations provide the clearest examples of agency problems and costs. In these big companies, ownership is spread across thousands of stockholders. Managers may feel like their policies and objectives have priority—they have a full-time dedication to management and an intimate understanding of the inner workings of the company, while many individual stockholders have just a small financial stake in the company and little knowledge about how the company operates. While they may feel justified, a manager who acts in opposition to shareholders’ wishes creates agency costs. In some cases, a manager doesn’t even need to act to create agency cost; if shareholders have reason to believe a manager will act against their wishes, they may decide to spend time and resources preventing those actions, and those expenditures are an agency cost. The agency problem is most acute when management goals maximize the interests of management at the expense of shareholder wealth. For example, management may not take on risky projects that would benefit the business because, if the project fails, they may lose their jobs. Shareholders, on the other hand, want to take on that risk so they can try to maximize the value of their ownership. Another fairly common example would include an increase in employee benefits. Shareholders may want to limit employee benefits to keep down costs and maximize profits (which may later be distributed as dividends).
Reducing the Agency Problem
Shareholders and managers aren’t always at odds. The two parties can usually find plenty to agree on, and there are actions shareholders can take to minimize agency costs. For example, shareholders can link managerial compensation to firm performance. This ties together their interests—if the goal of stockholder wealth maximization is reached, then managerial compensation is also maximized. Another strategy would be for shareholders to offer shares to managers below the market price, but only if the managers stay vested in the company for a certain number of years. While the scenarios above reduce the agency problem, they could be seen as agency costs in and of themselves. Dealing with the agency problem is never free. Extra compensation tied to firm performance is a cost that shareholders pay to reduce the agency problem—making it an agency cost. Offering shares at a reduced price—even if the shares have a vesting period—is another cost paid by shareholders.
